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Allan Gray on finding investment opportunities in Africa

Investing in Africa has its constraints, including illiquid markets, lack of credit ratings for debt instruments and an ever-changing regulatory environment, amongst other things. But the continent also presents a range of compelling opportunities for investors with a long-term orientation. This is according to Andrew Lapping, portfolio manager at African asset manager, Allan Gray.

Many global investors view the countries on the African continent as homogenous. This leads to blanket assumptions about trends, suggesting the different countries have similar characteristics. While this may be true in certain instances, there are also many differences.

One only has to consider unrelated political events across the continent, such as the Arab Spring in Egypt in 2011 or the post-election violence in Kenya in 2007 and 2008, to see that the landscape is far from uniform. The reality is the continent is a collection of 54 sovereign countries, with over 1,500 official languages and more than 1,000 listed businesses on multiple stock exchanges. In fact, the continent could not be more diverse.

Most investors in Africa also invest through the lens of liquidity and are biased towards the more liquid stocks with larger market capitalisations. This often results in the highly liquid stocks trading at a premium to less actively traded companies. Further to this, the less liquid stocks tend to be under-researched, which increases the likelihood of uncovering very compelling investments.

“Investors should focus on analysing businesses and the industries in which they operate, to build a clear picture of the business value, rather than chasing liquidity,” said Lapping.

Volatility a benefit

One of the great benefits of investing across the African continent is volatility, he added, as it means outcomes are less certain than in more developed markets.

“Volatility can result in dislocations between fair value of companies and the prices they trade at. The uncertainty may cause investors to shun a country, giving the calm, patient investor the chance to buy cheap assets,” noted Lapping.

“We think that the price volatility resulting from short-term news, political events or economic cycles can create opportunities to buy companies for less than they are worth. At Allan Gray we use a contrarian investment approach, which means we invest in a manner that differs from the conventional wisdom, when the consensus opinion appears to be wrong. Investing in this way across multiple African equity markets enhances the likelihood of finding attractive investment opportunities at any given time.”

While there are many differences between African countries and businesses, what is consistent is that African equity markets can be prone to big swings in investor sentiment. Swings in sentiment present opportunities, and  Lapping uses Egypt, Nigeria and Kenya to illustrate this point.

Egypt – a contrarian case study

In early 2013, Egypt was going through one of the most tumultuous periods in recent history. President Mohammed Morsi had seemingly lost popular support and street protests erupted across Egypt. During this period, investor sentiment towards Egypt was exceptionally negative and many Egyptian stocks were trading below their intrinsic value as investors exited the market. This offered an opportunity to buy good-quality businesses at discounted prices.

Investor sentiment turned dramatically after the military ousting of President Morsi in July 2013 and the situation calmed down. The EGX30 has appreciated 73% in dollars since the height of the troubles.

Kenyan banks versus Nigerian banks

Three years ago Kenya and the Kenyan banks were very out of favour. The largest bank, Kenya Commercial Bank (KCB), was trading at KES15.00  equal to tangible book value. It now seems the sector can do no wrong, growing advances and generating strong returns.

“In our opinion the risks are beginning to creep into Kenya, with growing dollar lending in both the private and the public sector and a current account deficit sitting at 9% of GDP,” Lapping commented.

On the other hand, sentiment towards Nigerian banks has gone from positive to outright fear. The fear is not without reason given the falling oil price, likely spike in bad debts and Boko Haram insurgency.

“It is indeed likely that there will be a lot of distress during the year, but it is important to remember that what a company earns in a particular year generally has little bearing on the intrinsic value of the business; what counts is the level of normal earnings through the cycle and the ability to grow those earnings,” said Lapping, noting that financial companies are a little different in this regard as they may go bankrupt before achieving normal earnings.

“A few Nigerian banks may run into serious difficulties or raise capital, but luckily the share prices are discounting this possibility.”

In Lapping’s view, over the long term, there is no reason why the Kenyan banking sector should be any more or less profitable than the Nigerian banking sector. “Over the past 10 years the return on equity for each of these sectors has been similar. But Kenyan banks now trade at multiples of the price to net asset value of the Nigerian banks – indicating that the market believes that Kenyan banks will permanently be much more profitable than their Nigerian counterparts,” he continued.

“We think the terrible sentiment and clear risks are giving us the opportunity to buy decent businesses, with favourable long-term prospects, at very attractive prices.”

For investors who seek geographical and currency diversification, who have a long-term investment horizon, who are not averse to risk, and who are prepared to wait for markets to recognise the true value of certain companies, investing across Africa presents interesting prospects.

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